Greenspan Shrugged

The former Fed chairman preaches fatalism about the "too big to fail" problem.

It wasn't very long ago that the world would hang on every word uttered by Alan Greenspan, chairman of the Federal Reserve from 1987 to 2006. But when the economist whom Bob Woodward dubbed "Maestro" gave a major speech on June 3 at the American Enterprise Institute, it attracted comparatively little attention. One likely reason is that the financial press was preoccupied by the current Fed chairman's newsworthy warning that same day that a growing deficit might impede economic recovery. A second likely reason is that the current very deep recession has brought about a steep decline in Greenspan's reputation as economic wise man. But I like to think that a third reason also played a role: Greenspan gave a lousy speech.

The essence of its lousiness was its fatalism. On the one hand, Greenspan said,

For years I have been concerned about the ever-larger size of our financial institutions. A decade ago, I noted that "megabanks being formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail." Federal Reserve research had been unable to find economies of scale in banking beyond a modest-sized institution. I often wondered: had bankers discovered economies of scale that Fed research had missed? It is clear, in retrospect, that they had not.

One highly disturbing consequence of the ["too-big-to-fail"]-bailout problem is that I can see no way to convince markets henceforth that every large financial institution, should the occasion arise, would be subject to being bailed out with taxpayer funds. The implicit subsidy that such notions spawn insidiously impairs the efficiency of finance and the allocation of capital. ...

Government guarantees of the liabilities of institutions viewed as too big to fail thwarts the competitive process that produces capital efficiency. It results in protected businesses having market and cost-of-capital advantages, but not efficiency advantages over firms not thought to be too big to fail. TBTF freezes obsolescent capital in place and impairs creative destruction—the primary means by which output per hour and standards of living are raised. Of all the regulatory challenges that have emerged out of this crisis, I view the TBTF problem and the TBTF precedents, now fresh in everyone's mind, as the most threatening to market efficiency and our economic future. [Italics mine.]

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In essence, Greenspan was saying that when banks become too big to fail, they are corrupted by the knowledge that the government won't let them fail. This presumed guarantee distorts the market and rewards risky behavior.

On the other hand, Greenspan said,

There are certain regulatory problems for which there are no good solutions. And TBTF is one of them.

Greenspan's main target was an option under consideration by the Obama administration to make the Fed a "systemic risk regulator," a plan whose details have yet to be sketched out. Nowhere did Greenspan utter the word antitrust, a much more obvious method to prevent corporations from becoming too big to fail. This is odd, because reinvigorating antitrust prosecution is not, like creating a "systemic risk regulator," a hypothetical policy but, rather, a stated goal of the Obama Justice Department under its new antitrust chief, Christine Varney. In a May 12 speech Varney said,

[W]e cannot develop sound antitrust policy merely on a case-by-case basis. Instead, as I have charged the Division's staff, we must consider the overall state of competition in the industries in which we are reviewing potentially anticompetitive conduct or mergers, or providing guidance to regulatory agencies charged with industry oversight. We thus must consider market trends and dynamics, and not lose sight of the broader impacts of antitrust enforcement.

To drive this point home, Varney has tossed out antitrust guidelines worked up in 2008 by the Bush administration on the grounds that they "raised too many hurdles" and "favored extreme caution." This decision has created mild hysteria on the right. But if the proliferation of economic entities too big to fail really is "the most threatening" regulatory problem to emerge from the current economic mess, it might not be a bad idea to, you know, address it.